Shareholders are their own worst enemy in bids

Ask a director who they would fear most in an unwelcome takeover and the answer will likely be the bidder, the regulator or the media. But for anyone who has been through an unsolicited bid in recent years, the real answer is your own shareholders.

And this is a recent phenomenon. Because the dynamics of shareholding have changed dramatically since the 1980s, when takeovers and takeover regulation really got going.

Let’s not dwell in the past though.

The scene in the present goes something like this: Some time after ASX trading ceases on a Friday, a chairman receives an approach letter from a potential bidder with an indicative price, seeking access to due diligence and also a board recommendation if everything checks out.

Even if the bidder does not couple this with acquiring a pre-bid stake, in nine out of 10 deals these days, the bidder has already sounded out major shareholders (primarily the large fund managers). And the bidder tells the chairman that it has their support. It is already one step ahead of the board.

So whether the board takes the strategic step of announcing the approach pre-market open on Monday, the bidder floats it into the media on Sunday afternoon, or a sounded shareholder breaks ranks, one way or other, the proposal soon becomes public.

What happens next, however, is the key event. The chairman takes the chief executive and the target financial adviser around to see major shareholders. To a person, the shareholders tell the board to push back hard and use every point of leverage to maximise price. They say that they never lent their support to the bidder, that access to due diligence and a recommendation are valuable and that they expect the board to negotiate a better deal. They tell the chairman they won’t accept the bid (although they decline to say this publicly because that would lock them in under ASIC’s “Truth in Takeovers" policy).

HOW THINGS UNRAVEL

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Nonetheless, emboldened by this, the board uses all the tools at its disposal to find more value from the bidder. It imposes conditions on due diligence access, it seeks alternative bidders, eventually it commissions an independent expert’s report and then rejects the proposal on grounds of inadequacy.

In subsequent discussions with the major shareholders there is no early sign that they will break ranks.

But as the bidder and target trade blows, things do start to unravel.

First, several shareholders engage in top-slicing. This is the art of selling down 10 per cent - 15 per cent of their shareholding as a form of insurance that captures a small piece of the market uplift arising from the bid. Some call it “schmuck insurance". The shares aggregate into the hands of hedge funds and arbitrageurs who will always be sellers. They will never thank the board for defeating a bid. And those same hedge funds and “arbs" will be in the market picking up any stray stock. Before too long, a large percentage of stock will be in their hands.

Meanwhile, there will be other situational funds that accumulate stock to capitalise on features of the bid – such as the availability of franking credits where special dividends are part of the composition of consideration.

Then there are the most dangerous shareholders of all. Those who hold meaningful shareholdings in both bidder and target. If the holding in the bidder is large, there is only one allegiance on their mind. We have seen numerous takeovers where this alone was the death knell for the target board’s efforts to stave off the bid. Unfortunately, in a small investment community like Australia, where sector focus has few choices, this situation is incredibly common.

At some point the bidder ups the bid price with just a small bump, coupled with either express or hinted noises that there is nothing left in the tank. At this point, shareholders cannot hide their irritation. The board will hear anger towards the bidder, but in a lot of cases it is more complex.

LACK OF UNITY

Now the conversations with major shareholders start to change complexion. Well, yes, they wanted you to fight the bid, but they don’t want you to lose it either. They’d rather accept the inadequate price than have you push so hard that the bidder walks. They have no recollection of the early discussions, just of the fact that no counter-bid was found and no material bid price increase ever forthcoming.

Next the bidder establishes an institutional acceptance facility to help build momentum without locking major shareholders into acceptance of the bid. These facilities allow institutions to place “acceptance instructions with a trustee, providing a free swing for large shareholders while sending a message to the target board that shareholders want the bid to succeed. But fancy this – it fills up first with those very same conflicted shareholders, hedge funds and arbs.

Once that happens, others follow suit. They don’t like the bid. In fact they hate it. But having marked-to-market at the last quarter, they are reluctantly happy to take a profit in this one. Especially in times like the present where there is so little good news in the investment landscape. Funds feel compelled to take the money and run.

The story reinforces why there is so much need for boards to stay close to their shareholders, but also why even that is near impossible with these shifting sands.

So whom should boards fear the most? Well it is clear that once a company is in play in this country, it is their own constituents.

However, at a macro level, shareholders are their own worst enemy. Because the modern-day bidder knows all this. They have seen it play out so many times in recent years. And the effect is that takeover premiums have come down and bid price increases are less significant than once upon a time. Even back in the 1980s, the words “inadequate and opportunistic" lost their impact. However, we have seen in recent years – and even very recently – bids that undervalue targets dramatically but are successful because shareholders were unwilling to stand by the board.